04 Jul Subprime Bond Market: Why it Matters to You
Think consumers borrow too much money? Hedge funds make shopaholics look conservative. A hedge fund can take a dollar from wealthy or institutional investors, borrow several times that dollar, and then buy high risk investments for handsome returns or terrifying losses very quickly. And they currently do so largely out of the public eye.
Many hedge funds buy bonds based on subprime mortgages written to risky borrowers. In the current volatile market, no one can be certain what these bonds are now really worth. So just like many of subprime loans based on inflated appraisals that underlie the bonds, the bonds themselves are hard to put a price on. And they were bought with almost no down payment.
So? A lot of rich people might be betting the wrong way on bonds. Let me pull out my very tiny violin and play a dirge. But actually we don’t have a choice, we have to care. Partly because the “wealthy investor” who takes the hit of a failing hedge fund may be you or me, by way of your 401(k) or pension plan or my mutual fund. Remember the Enron employees who listened to Ken Lay and bought stock in the company just as it all went bad? We may be able to sympathize at a whole new level eventually.
That’s bad enough but at least it only means we can never retire, right? Well if the subprime bond market gets dramatically worse, a great “unwinding” of debt will happen which will inevitably drive up interests which, in turn, will drive up costs for everyone — including subprime borrowers who have adjustable rate mortgages. And if ARM rates adjust upwards constantly, more ARM borrowers will have to walk away from their homes, causing more subprime losses, and more subprime bond defaults, and so on.
How bad are the numbers? Bank of America has estimated that $500 billion of ARMs will adjust upwards this year and an additional $700 billion will adjust next year. A large proportion of these are subprime loans and this year’s adjustments alone average in the range of 2%. Doesn’t sound like a lot “2%” but that’s over $200 per month on a $150,000 mortgage. If you were having trouble making payments, and if you have credit card minimum payments — also going up as rates go up — and gas prices keep going up, it doesn’t take a rocket scientist to see $200/month is too much. Multiply that by thousands and thousands of squeezed families and you see defaults will climb higher fast.
Bill Gross of PIMCO, the largest bond fund management company, has been warning about this for anyone who cares to listen. He points out that just at the current rate of default (7%) on subprime loans, holders of the highest-risk (BBB, junk) bonds are already facing losses of their entire investment because the investment was bought with so much borrowed money. If the default rates climb to 10% then even “high” (A and higher) quality bond investors who borrowed (“leveraged”) heavily to make their investments will take massive losses.
When the hedge funds that borrowed to invest in these bonds start taking large losses, their lenders typically will have a hard choice to make: Lend them more money in one way or another to help them keep going or take the collateral — the bonds. But most lenders will need to sell the bonds for whatever they can get (or hang on and hope homeowners will pay the underlying mortgages or foreclose their homes and try to collect that way). With more bonds (or houses) on the market, the price falls. So the lenders start taking larger and larger losses. As night follows day, interest rates go up and money gets “tighter” for risky borrowers. And those risky borrowers, if they can’t borrow money, also can’t buy the houses the lenders have foreclosed on and need to resell in order to reinvest in lending to new home-buyers. It could be years before the shocks to the financial system resolve themselves.
For more: Jay Fleishman’s earlier note on the subprime meltdown;
Chip Parker’s notes on the need for greater regulation of subprime lenders and how little the federal government is doing to help;
And, Kurt O’Keefe’s note today on the connections between Wall Street and predatory subprime lenders.
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